Part 2: A walk along Risk Road with Jim Hall
Investing in a Slow-Growth world
At Mawer, we spend a great deal of time asking and answering the question: So What? A company’s share price is down 6%...so what? A central bank moved interest rates up…so what?” Google re-named itself Alphabet…so what?”
It is not always an easy question to answer and often leads us to ask even more questions in an effort to develop key investment insights. “So what?” is one of the questions that can lead us to investment action (or inaction) in our process of building well-diversified, resilient portfolios. In an effort to pass on our “so what” learnings, I interviewed our Chief Investment Officer, Jim Hall, with specific questions pertaining to his views on risks in the current environment.
CW: Jim, last time we discussed how Mawer’s quarterly risk review ranks macro risks on both probability of occurrence and degree of severity. Remind us why this is part of the investment process.
JH: It is not enough to just look at potential risks. We need to ask ourselves is it something we need to do something about? Is this something upon which we need to act? Is it important? That’s the value in evaluating these risks on both probability of occurrence and severity of consequence.
CW: Last time we spoke we tackled two biggies: deflation and rising interest rates. We left off with an agreement to discuss the growing concerns over global growth. Is a slow-growth world an important risk?
JH: A slow-growth world has been high in our risk rankings for many quarters. It’s a biggie and a good follow up to our deflation discussion. In a deflationary world, growth is going to be in short supply. It will command a premium. Our investment efforts, therefore, need to focus on situations that can demonstrate secular growth, or sustained real economic growth at an above-average rate.
CW: What might those situations look like at a company level?
JH: One way that people often talk about is growing through more merger and acquisition activity (M&A). Companies will be more direct about trying to manufacture growth through buying or selling. As a result, there will be targets and buyers and more activity. I say ‘manufacture’ growth because typically M&A is motivated either by acquiring a similar business and realizing significant cost savings or by acquiring complementary products and selling more across the business channel. It’s often about growing earnings by cutting costs rather than growing sales.
CW: What is Mawer’s approach to M&A opportunities.
JH: Awareness but not prediction. It’s not an area where we think we can consistently add value by trying to identify targets. Our approach is to evaluate deals that are being done or have been done as a reflection on management. If there’s a particularly good value-creating deal, we’ll give management a higher ranking. If management is buying just for the sake of buying, then we’ll assign them a lower ranking.
CW: So there's no overarching view that M&A is a growth catalyst in a slow-growth world?
JH: While M&A is a source of possible growth in earnings it’s not really a secular growth catalyst, it's often just financial engineering. It’s also usually one-time in nature. That doesn’t mean there isn’t a real economic benefit though. Cutting costs and becoming more productive does deliver a real financial benefit. Alternatively, if a company can buy a business in one market and sell its products in multiple markets in which it already has sales channels—then that can generate real economic growth. So there are some good reasons to consider M&A as part of the growth picture, it's just we don't explicitly build it into our valuation models because it is usually difficult to predict and often unsustainable. In a slow-growth world, we expect M&A to be pursued, but we prefer to look at it as a tool to evaluate management's ability to create wealth and earn an attractive return on the capital.
CW: So I’m hearing that at the company level, there are opportunities to offset the slow-growth trend. I wonder, though, are there second-level impacts of a slow-growth world?
JH: A good question. Yes, there could be a few of those. Higher taxes could be an outcome of government policy that has had little success in accelerating economic growth. Global government debt has increased since 2008 but it appears that growing out of that debt could be difficult. So one alternative is to raise taxes. The investment “so what?” lies in how we approach the issue. It means that in our valuation models, we may need to model for a higher tax rate and slower growth at the same time. Ultimately, we have to be very careful in what we’re paying for growth because it might not actually be there.
CW: Does the worrying combination of high debt and low growth apply only to governments?
JH: Debt is a risk whether it's at the company level, country level, or personal level. In a slow-growth world, the debt burden is even heavier because you can't grow out of that burden.
CW: Thanks for this Jim. As I’m hearing it from you, there are a few keys to investing in a slow growth world.
First, avoid debt because slow growth limits your ability to pay it off.
Second, seek secular growth because that is distinctive (and valuable) in a slow-growth world.
Third, pay the right price for that growth.
JH: That captures it.
CW: Where do you want to take the conversation next time?
JH: Well, we've covered deflation, and now a slow-growth world. These situations are connected by one important factor. Let’s tackle technological disruption.